Volatility Is Certain, But It Doesn't Have To Be Risky

 |  Includes: DIA, SPY
by: Garvin Jabusch

That's because risk and uncertainty are not the same thing.

It's unavoidable that our Green Alpha portfolios get caught up in short-term market volatility, such as a general downdraft for perceived "growth" equities like the one we've experienced in April and May this year. But we believe that by carefully selecting growth and value stocks with great fundamentals, we are building portfolios that stand every chance of being early to recover, and on that basis we consider these inevitable periods of market consolidation attractive entry points within our methodological approach.

This April, and thus far in May, geopolitical events and perceived slowing in China's economic growth (among other things) have caused a general shift away from growth stocks to more traditional value stocks. Anything thought of as high momentum or high growth has been sold in favor of more traditional blue chips -- here I cite that the DJIA 30 was the best performing broad index in April. Of course, the possibility exists that this trend may continue for a while, but the possibility equally exists that the shift may have run its course and that now traders will begin to hunt for bargains among the growth stocks that have pulled back. Either way, the point is that stocks with good fundamentals (and working in rapidly growing areas -- like the solutions to society's most pressing systemic threats) are not declining due to company-integral issues, but rather are being caught in generalized negative market sentiment.

Price declines that are not based on company-specific fundamentals do not reflect the true value of a particular firm, and thus represent a market inefficiency we can exploit. We believe in long-term, buy-and-hold investing, and so we tend to view these pullbacks as opportunities for us and for like-minded investors to acquire shares at lower prices.

While we do take advantage of such volatility, we don't actually manage our portfolios to short-term factors. We focus not on what is important this month or this quarter, but on things that are fundamentally true, always -- things such as mitigating resource scarcity and adapting to the effects of climate change.

We believe our portfolios represent a good intersection of growth at a reasonable value, and the April/May pullback has only made that more true. For example, the average price-to-book ratio in our Sierra Club Green Alpha (SCGA) Portfolio is now 2.6, equal to that of the S&P500 at 2.64; and the weighted average earnings-per-share (EPS) growth rate (next 12 months) of the SCGA Portfolio is now 67 percent, where the SPX is 9.94 percent. So we've assembled a portfolio with 680 percent greater earnings growth than the S&P 500 index, but which simultaneously trades at the same price-to-book valuation as that benchmark. (Figures as of 5/14/2014, data from Thomson Reuters.)

In our mutual fund (ticker NEXTX), the picture is much the same. Here, the weighted average price-to-book ratio is 2.3, below that of the average S&P 500 stock, while NEXTX's EPS growth rate is 59.64 percent for the forward year, some six times faster growth than that offered by the S&P 500 average.

From this perspective, it's hard to see where the S&P 500 can be considered less risky than our fund, involving as it does investing in far slower-growing firms, and at richer valuations, than does NEXTX.

Risk vs. Uncertainty

Many people confuse and conflate these two terms but in reality, as in portfolio management, they actually mean different things.

Risk is quantified, measured; it uses numbers that exist today and can be crunched ten ways from Sunday. As such though, risk is necessarily backward-looking. Risk metrics can tell you all you need to know about how assets and portfolios performed in the past, and exactly what their "risk-adjusted" returns were. Risk gives you something quantitative and concrete to hang your hat on; it can be objectively analyzed without the need to make too many assumptions.

Uncertainty refers to what we don't know for sure about the present and can't know about the future.

For example, to cite a common area of risk measurement, I can tell you that through April 30 of 2014, the mutual fund rating agency Morningstar calculated that NEXTX had a trailing one-year upside capture of 149.96 percent, and a full-year downside capture of 69.71 percent, versus the S&P 500 total return. (Information from Morningstar.com) This means that over the past year, on an average day that the market was up, our fund performed approximately 50 percent better than the S&P 500, and on an average down market day, the fund was down only 69 percent as much as the index overall. As happy as I am with this trailing year result, it tells us very little about what results the fund may see in the coming year, or in any future period.

Uncertainty by its nature cannot be specifically measured. In our case, we look to invest in companies that our projections suggest will continue to grow rapidly because they have solid fundamentals and offer the most promising solutions to our most dangerous systemic threats. These companies are growing and will need to continue to grow at very rapid rates in order to be in any way commensurate with those threats. To illustrate, we know we are beginning to confront water scarcity, and we know we need far greater supplies of non-carbon-emitting energy. Do we know with certainty which companies addressing these concerns will have the best market performance? No. We are uncertain. But we do know that the world is rapidly mobilizing to address its systematic issues, and that the more attractively valued companies meeting the challenge of mitigating those issues will have far better than average growth potential.

Imagining, modeling, and building portfolios of firms that are leaders in offering improvements to economic efficiencies and sustainability frontiers is both far more interesting than exact but irreproducible risk numbers from the past and also far more likely to result in selection of stocks with the best chances of thriving into the future. We believe we have to concentrate on selecting the most innovative, adaptive firms able to embrace uncertainty. Measurable risk numbers -- occurring as they do in the past -- are no longer the most reliable tools.

So, embrace uncertainty, let go of traditional risk, and use volatility.

Knowledge, innovation and technology are changing fast. A century ago, the totality of human knowledge was doubling every 100 years or so. Now, it's doubling every 13 months. Soon, according to some smart people at IBM, it may be doubling every 11 hours. The future will be nothing like the past. It's far better to proactively manage into the uncertainty of that future than it is to spend too much time reflecting on how great our risk metrics were. Last year.

Disclosure: None